A Buy-Sell: Cheap To Fund, But Expensive To Form?

A Buy-Sell: Cheap To Fund, But Expensive To Form?

Nothing saps the thrill of owning a sassy new automobile more than the increased premiums on the car insurance that are about half the amount of the monthly payment on your Little Deuce Coupe.

And those nifty printer/scanner/copier/faxing machines that they are practically giving away at Paper-clips ‘R’ Us don’t seem so nifty when you replace the ink cartridge(s) for the first time at a cost about equal to the original purchase price.

The phenomenon of deferred-sticker-shock can put the bite on what might otherwise be a nice insurance sale to fund a buy-sell agreement.

As an example:

Three young, non-smoking, healthy entrepreneurs, let’s call them Sharon, Caroline and Andrea, operate a promising LLC taxed as an S-Corp.  They agree to buy out the estate of any that might prematurely pass for $1,000,000.  They take out a policy on each for that amount to fund the buy-out.  On each policy the two non-insureds jointly own the policy on the insured, e.g. Sharon and Caroline own the policy on Andrea.

So Andrea dies and the $1,000,000 from her policy is used to buy her interest from her estate.  That’s all good as far as it goes.  But what happens to Andrea’s interest in the two remaining policies?  Well, because they were owned jointly, Sharon is now the sole owner of the policy on Caroline and vice versa.  The problem is that the shift in ownership caused by Andrea’s death is probably a transfer-for-value.  Up to one-half the death benefit could be subject to income tax if paid.

The most common exception to the TFV rule is an ownership change between partners.  The problem here is that the ladies’ company is taxed as an S-Corp and there may be reasons they don’t want to change to partnership taxation.  And the cost of creating a partnership simply to handle the insurance may be several times the annual premium on the insurance, all to avoid a tax hit that will only occur if a second death occurs while they are still operating the business.

Perhaps the best you can do is to suggest they discuss with their tax advisor the feasibility of an ownership reset if a first death occurs.  This would involve 1) transferring the remaining policies back to the insured (another TFV exception that also cleanses the policy of the taint of the TFV), 2) the creation of a partnership between the survivors (at least the cost is incurred only when needed), and 3) exchanging the policies to establish cross-ownership without any TFV issues.

The suggestion should be reduced to a writing that they can take to their tax advisor and that you can also keep in your file to document that you raised the issue.  We can help with that and also explain the problem to the client and their advisor.  Give us a call regarding this and any planning questions that come up, especially in your clients’ buy-sell planning.

Long ago in the pre-Tesla days of electric car design, a cartoon in the Saturday Evening Post (whatever that is) showed a salesman breaking down the cost of an electrical car to a prospective buyer:  “. . . and that will be $1500 for the automobile, and $35,000 for the extension cord.”